Tuesday, April 15, 2008

Hedge Funds Buying Distressed Securities

Hedge fund managers are poised to leap into the pool of distressed and incorrectly priced securities created by the credit crunch.

Swiss private bank Union Bancaire Privée and Swiss manager Gottex Fund Management are launching funds that will invest in debt they believe is temporarily undervalued as a result of market conditions.

The opportunity is on a large scale.

The International Monetary Fund last week put the total cost of the credit squeeze to the global economy at almost $1 trillion (€640bn) and figures from BNP Paribas and Bank of America put the global backlog of unsold acquisition finance on banks’ balance sheets—only a part of the overall opportunity—at about $282bn at the end of January.

But even the most bullish hedge fund managers are proceeding with caution, suggesting in the short term they may not make much of a dent in the backlog, or ride to the rescue of asset-backed securities markets.

Meanwhile, private equity firms, some of which have run credit funds for years, are joining in the bargain hunting.

Last week, US private equity houses TPG, Apollo and Blackstone were in negotiations to acquire $12bn of leveraged loans from Citigroup, and the Carlyle Group has launched a fund to do similar deals. This is despite any possible conflicts of interest involved in these firms purchasing debt issued by their own portfolio companies.

Private equity firms are better placed because they have the funds in place, as well as hundreds of billions of dollars in unused commitments from institutional investors—$176bn has been raised so far this year, according to analysts Preqin.

Buyout firms also have a vested interest in getting the debt markets moving. Hedge funds, by comparison, have to spend time and money on the road raising fresh capital.

Some think the effort is worth it.

Union Bancaire Privée, which is one of the world’s largest investors in hedge funds, launched two funds of funds last week to hunt for distressed opportunities, and is seeking to raise up to $1bn from institutional investors and wealthy individuals.

One of the funds will invest across the troubled credit markets, putting 75% of its capital in hedge funds and the remainder in private equity funds. It will look for undervalued bank loans and corporate debt, asset backed securities, as well as opportunities in rescue or turnround situations.

Shoaib Khan, a senior portfolio manager at UBP, said: “While the basket of bank loans trading at stressed and distressed levels may not be attractive, there are situations within the basket that are attractive.

“It is our intention to capture these select opportunities trading at cheap valuations, but have good collateral and covenants in order to provide downside protection.”

The funds will be unleveraged, though some of the underlying managers may borrow temporarily to fund their positions. Khan, who will manage the hedge fund portion, believes net returns of 15% to 20% a year are possible without leverage.

He said: “It is not our objective to have leverage provide us the returns. The funds we are targeting to include in the product do not use leverage.”

February’s collapse of a $2bn fund run by UK manager Peloton Partners illustrated the perils of borrowing to buy too soon.

Peloton took out $7bn of debt from its bankers in order to buy a $9bn portfolio of mortgage-backed securities, but when they fell further in value, the bankers declined to extend their loans.

Other managers are looking to exploit the credit market turbulence using strategies that are less bold. Gottex is raising money for a fund to invest in “recovering” assets, which it defines as high-quality debt that it believes is undervalued by the market. This fund will be unleveraged, and Gottex says it will specifically eschew distressed situations.

Andre Keijsers, a managing director at Gottex, said: “The recovery fund will look for depressed assets, such as mortgages, that have been hammered down together with the rest of their sector but should have higher valuations.

“Out of 100 securities in the sector there might be two or three interesting opportunities, but if you can hold them for the long term, perhaps two to three years, you can ride out the market troubles. Recovery to the mean is a very powerful force and over time it usually happens.”

Gottex has no formal target for the size of the fund but says it has capacity for as much as $6bn.

Three quarters of the assets will be invested in underlying hedge funds but up to 25% will be held directly in debt securities, and there are likely to be redemption restrictions commensurate with an investment horizon of two to four years, Keijsers said.

Managers such as the UK’s Thames River Capital and Swiss-owned GAM, which run funds of hedge funds, have studied the prospects for launching funds to buy bank debt but are holding back for now.

A spokeswoman for GAM said: “The feeling is that it is a little bit too early. We would not launch such a fund unless there was demand from our clients.”